Question

Discuss how various budgets interact with each other – example could be the cash budget and the sales and purchases budget or the capital budget and the cash budget and the budgeted balance sheet? How can we use budgets to create a set of pro-forma financial statements to serve as targets for management and investors alike to track our performance against?

Answer 1

Various budgets interact with each other because few elements of a budget are derived or depended on some elements of another budget and because few elements of different budget bear a common financial or accounting transaction.

For example take the case of a cash budget. A cash budget is tied to a company’s operating budget and its capital expenditure budget. Operating budget for a business consists of revenues and associated expenses with regards to day to day operations of the business. Categories of operating budgets are revenue, salaries, and other expenses. All these items involve cash outflow.

Capital expenditure budget (or simply capital budgets) involves purchase of large assets and equipment. This too involves cash outflow.

Now a cash budget ties together the operating budget and the capital budget. It takes into account timing of the different payments and receipts from the operating budget and capital budget. Thus all the three budgets i.e. cash, operating and capital budgets are tied together and this is how they interact with one another.

Budgets can be used to create a set of pro-forma financial statements to serve as targets for management and investors alike to track our performance against. The pro forma income statement is derived by the budgeted income and costs. The capital budget will help in preparing the asset side of the balance sheet to a large extent. Pro forma financial statements are also known as budgeted financial statements as they are derived from the different budgets that have been prepared by a company.